IRA Financial’s Adam Bergman Esq. discusses Special Purpose Acquisition Companies (SPACs), what they are, their advantages and why it makes sense to use your IRA to invest in them.
SPACs are defined as blank-check companies formed by sponsors who believe that their experience and reputations will allow them to identify and complete a business combination transaction with a target company that will ultimately be a successful public company.
Special Purpose Acquisition Companies have exploded in the last year or so, raising about $64 billion, which is almost as much as what traditional IPOs brought in. Once public, the company has no operations. It simply holds cash—typically, $200 million to $400 million—and has two years to find a private company with which to merge and thereby bring public. The sponsor invests some of its own capital in the SPAC as well but takes an additional 20% interest in the SPAC at a nominal price.
Advantages of SPACs
For the Seller:
- Cheaper way to go public than an IPO
- Selling to a SPAC can add up to 20% to the sale price compared to a typical private equity deal. Being acquired by a SPAC can also offer business owners what is essentially a faster IPO process under the guidance of an experienced partner
- Startups going public through SPACs can make rosy projections about future results with less risk of facing lawsuits than they would if disclosing those figures in a traditional IPO
For the Promoter:
- The sponsor invests some of its own capital in the SPAC as well but takes an additional 20% interest in the SPAC at a nominal price
- The rough rule of thumb is 2% of the SPAC value, plus $2 million
The SPACs Strategy for the Wise
Invest in “units” containing one share and one or two additional securities—a “right” and/or a warrant. The price is $10 per unit, but if you don’t want to participate in the merger, you can redeem your shares for $10 plus interest and keep the warrants and rights for free.
This is the how the strategy works:
This is a tremendous deal for IPO investors who redeem their shares. A right gives a unit holder an additional one-tenth of a SPAC share when the merger is complete. A typical warrant gives the holder an option to buy between one-half and one share at an exercise price of $11.50 any time over five years following the SPAC’s merger. On average, if an investor buys units in a SPAC public offering, redeems its shares and keeps or sells its warrants and rights, the investor’s annualized return is more than 10% with no downside risk.
Who wins?
The promoters and initial IPO investors.
Between January 2019 and June 2020 and found that, on average, they lost 12% of their value within six months following the merger, while the Nasdaq rose roughly 30%. Even with these drops in share price, the 20% that the sponsor gets essentially for free provides a nice return on its investment. The sponsors of these SPACs enjoyed a return on investment of more than 500% as of the end of 2020.
hat is because many SPACs reward their sponsors for engineering a deal by allowing them to buy 20% of the company for just $25,000. Called the sponsor promote, this feature can be lucrative for a SPAC’s founders, handing them equity stakes worth millions of dollars while diluting the value of shares held by external investors, the paper’s authors found.
Analysts and academics say it can encourage SPACs to do bad deals, by rewarding their teams even if the company’s shares slump after a deal closes. SPAC founders are very incentivized to do a deal,
Who loses?
While shareholders who remain invested through the merger do poorly. The sponsors’ essentially free shares and the IPO investors’ free warrants and rights dilute the returns to investors. The shareholders who pay for their investments are, in effect, sharing the value of the merged company with others who did not. Our study of SPACs that merged between January 2019 and June 2020 found that, at the time of their merger, “most SPACs had less than $6.75 a share in cash but ascribed a $10 value to those shares when they merged.”
Critics worry the SPAC boom could end badly for smaller investors who don’t understand the risks.
SPACs have a poor record of delivering returns. Of 107 that have gone public since 2015 and executed deals, the average return on their common stock has been a loss of 1.4%, according to Renaissance Capital, a research and investment-management firm. During the same period, the average return of companies that went public via IPOs was 49%, the firm says.
However, SPACs have a crucial feature to protect investors: Before one does a deal, its investors may redeem their shares for cash, collecting its IPO price, usually $10 a share, plus interest
Hedge funds and private-equity firms are typically the major investors in SPACs before they do a deal, but the structure has recently drawn interest from individual investors.
Using an IRA to Invest in SPACs
When using a retirement account, such as an IRA, you receive the tax benefits of the plan. This is especially true when using a Roth IRA. When using after-tax funds to make an investment into a SPAC, the gains generated grow tax free. All qualified withdrawals, including earnings, are tax free when you distribute them during retirement. Check out a recent article we wrote about SPACs and the Roth IRA.
SPACs have become quite interesting with more investors looking to make a big profit, especially in lieu of the COVID-19 pandemic. Businesses looking to go public have grown as well. Together, along with your retirement account, you can make a big score.
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